Abstract of the paper
This paper develops an equilibrium model of the determination of exchange rates and
prices of goods.
Changes in relative prices of goods, due to supply or demand shifts, induce changes in
exchange rates and deviations from purchasing power parity.
These changes may create a correlation between the exchange rate and the terms of trade,
but this correlation cannot be exploited by the government to affect the terms of trade by
foreign exchange market operations.
Exchange rate and their rate of change
are more volatile than the change of
the relative price.
Frequent changes in the exchange rate have failed to resemble
contemporaneous changes in the relative price level in either
magnitude or direction
Problem in determination of
This paper proposes an alternative equilibrium explanation of ex- change rate
The explanation is based on a model of the simultaneous determination of
exchange rates and relative prices of different goods in international trade in an
intertemporal framework with uncertainty and rational expectations
Key points of the paper
Exchange rate may be volatile i.e. changes in the exchange rate will be more than the changes in
the relative prices of good in two countries
The exchange rate and the term of trade cannot exploited by the government
Creates uncertainty even when all markets are in equilibrium
Deviates from PPP
Correlation of the exchange rate and the term of trade
for the countries with homogenous monetary policy
•These relative price changes were emphasized in the traditional literature on exchange
rates but have been neglected in the recent exchange rate literature associated with the
•Government commercial policies such as tariff's or quotas can, however, affect the
exchange rate by changing the terms of' trade. Cassel (1922) (discussed the role of
commercial policies in causing deviations from purchasing power parity. Muss (1974)
examined the effects of commercial policies on the balance of' payments, and his
argument could be applied to flexible exchange rate case; the effect he emphasizes is the
change in real income and hence the domestic demand for domestic money due to a
Factor affecting determination of exchange rate
Higher domestic inflation means less demand for domestic goods and
more demand for foreign goods (increased demand for foreign currency),
causing increasing in exchange rate i.e. depreciation of domestic currency.
Higher domestic (real) interest rates attract investment funds causing a
decrease in demand for foreign currency and an increase in supply of
Stronger economic growth attracts investment funds causing a decrease in
demand for foreign currency and an increase in supply of foreign currency.
Changes in future expectations:
Any improvement in future expectations regarding the domestic currency
or economy will decrease the demand for foreign currency .
Maintain weak currency to improve export competitiveness.
A theory of long-term equilibrium exchange rates based on relative price
levels of two countries.
The theory of purchasing power parity (PPP) explains movements in the
exchange rate between two countries' currencies by changes in the countries'
Law of one price
Identical goods sold in different countries must sell for the same price
when their prices are expressed in terms of the same currency.
This law applies only in competitive markets, free of transport costs
and official barriers to trade
The Relationship Between PPP and the Law of One Price
•The law of one price applies to individual commodities, while PPP applies to the general
•If the law of one price holds true for every commodity, PPP must hold automatically for
the same reference baskets across countries if each commodity is traded.
TWO TYPES OF PURCHASINGPOWERPARITY
1. Absolute Purchasing Power Parity
2. Relative Purchasing Power Parity
The Absolute Purchasing Power Parity
where pd is the domestic
price index, pf the foreign price index,
and e is the spot exchange rate
(domestic currency units per unit of
the foreign currency).
Relative PPP is said to hold if
e=pd - pf
Relative PPP states that the percentage
change in the exchange rate is equal to
the percentage change in the domestic
price level minus the percentage change
in the foreign price level
Absolute PPP indicates that the exchange rate between two currencies is equal to the
ratio of the two countries’ price indexes.
The exchange rate is a nominal value, that is, its value is dependent on current
If absolute PPP holds, then relative PPP also holds. If absolute PPP does not hold,
relative PPP may still hold.
Real events (demand and supply socks) which cause relative price changes are often
random or unexpected
Problems with Law of One Price
The more homogeneous goods are, the more the law of one price is expected to hold
but it could not be found in reality
There are obstacles to equalization of product prices across countries, including
differentiated products and costly information.
Transportation cost and restricting trade policies (such as tariff and quatas are present)
Reasons for Deviations from PPP
The law of one price does not apply to differentiated products or to globally
Prices may differ due to freight costs or tariffs.
Relative price changes may result from real economic events such as changing
tastes, bad weather, or government policy.
Since people in different countries consume different goods, national price
indexes may not be comparable.
Assets market approach for the determination of exchange rate
demand and supply of
The portfolio balance approach points out the
imperfect substitution between home assets and
foreign assets .
Change in exchange rate due to change in demand or supply of money
Demand for money is the
Increasing function of income
and the decreasing function of
If, e= pd- pf
Exchange rater depends upon,
Difference in the demand for money
Difference in the income
Difference in the rate of interest
An increase in domestic money supply causes an excess money supply and results
in a price increase in home country and a depreciation of domestic currency.
An increase in domestic national income brings about more money demand , the
exchange rate falls or in other words, domestic currency appreciates.
A rise in home interest rate reduces money demand and causes the price level to
increase. The exchange rate then rises causing domestic currency to depreciates.
A rise in the expectation of future exchange rates will result in an immediate
depreciation of domestic currency.
Role of relative price change
due to real disturbance .
Change in money supply
Change in stock of money
Increases the nominal prices of good and service
Increases the nominal prices of foreign exchange
Relative price change and exchange rate
change in each
Terms of trade
Shifts in the demand and supply
Correlation is high for
the country with more
Relationship of terms of trade and exchange rate
Appreciation the currency
Favorable terms of trade
Depreciation of currency
Unfavorable terms of trade
Terms of trade: ratio of the export price/import price
px/py for country1
py/px for nation 2 ,
Relationship with inflation and the exchange rate
High inflation in the country
Low inflation in the country
Countries with persistently high levels of inflation tend to experience exchange rate
depreciation, while low inflation countries have appreciating exchange rates. Thus,
inflation and exchange rates tend to move in opposite directions . There is an inverse
relationship between the two variables.
Inflation only affects purchasing power if the rise happens unevenly across prices of
goods and factors of production acros the world.
o Ms1 and Ms2 are nominal quantities of money supply .
o P1 and P2 is the price of good one and good two.
o Country one is the domestic country and country two is the foreign
o e is the exchange rate where, e=Pd/Pf
The real quantity of money supply remains constant for each country
i.e.M1/P1 and M2/P2 is constant over time.
The relative prices of one good in terms of other good = T=P1/e*P2(T = relative prices of goods)
If relative price shifts i.e. price of good one increases and price of good two decreases
then demand for good two increases and good one decreases.
Demand for the domestic goods decreases, and foreign good
increases leading to appreciation of the foreign currency and
depreciation of the domestic currency.
Exchange rate is high in domestic country-depreciation of the currency
Exchange rate is low in foreign country-appreciation of the currency
Md=f (i, e∏)
Where, md = demand for money,
I = rate of interest
e∏ = expected inflation rates
we can know,
1 future rate of monetary growth
2 inflation on the current exchange rate and the price level
If the expected inflation is going to increase the domestic currency will depreciates.
Relationship between exchange rate and relative prices.
ASSUMPTION OF THE MODEL.
•Money is only used for precautionary purpose and transactioanary purpose
•Real demand for money is not constant .i.e. M1/P1 and M2/P2.]
• A change in relative price T is partially effected by e and partially effected byP1
•Good1 is produce in country 1and good 2 is produce in country 2
•Goods are not stored.
•Shocks to production is independent across good and over time
Individual 1= domestic country (1)
Individual 2=foreign country (2)
Utility maximization of individual 1
Where, C11, C12 Shows the consumption of individual 1
is the current period utility function
Is the discount term
Utility maximization of individual 2
Output=(Y1 , Y2)
Subject to the constraints.
Where, c11 and c22 - consumption of good 1 and good 2
m11- domestic money, m12- foreign currency
e - exchange rate
t1-Tranfer payment of m1 to individual 1 (negative values if taxes)
m’11 and m’12 holding of domestic and foreign currency at the end of the period
Role of the government
To determine transfer payment or taxes (T1, T2)
Buying or selling of foreign exchange
Ms 1 and Ms2 –nominal quantities of money 1 and 2 at the beginning of the period
At the end of the period, f=foreign exchange market intervention taken by govt.
Equilibrium price vector=p=(p1, p2, e)
C=f(pd, pf, e, md, mf, R, t )
Dynamics of the model
Expectation of the individual
The model gives more emphasis to the rational expectation of the individual on the expected
Value of the future money growth and the future inflation rate.
Given the expectation of the future values the individual will be able to formulate his demand
And prices of the commodity
The individual is assumed to be rational and wants to maximize his utility to attain equilibrium
Income effect and the substitution effects
If substitution effects dominates the income effects, then increase in the initial
holdings of money will increase both demand for goods and demand of money
Increase in price of domestic good increases the demand for both (md,mf)currency
and the demand for good two, therefore the domestic currency depreciate and foreign
Currency appreciates .
Increase in the exchange rate of domestic currency i.e depreciation of domestic currency
Increase the demand for both domestic good and domestic currency.
Implication of the model
CURRENT ACCOUNT vs.
GDP vs. INTEREST RATE
Whenever the interest rate rises return on investment
increases , both for private and public investors. When
interest rate raises the country currency appreciates .The
main reason behind this appreciation is that more and
more people come inside the county and invest more .
When there is a surplus balance in the current account
the home currency appreciates while in case of the
deficit in the current account the home currency
When the gross domestic product increase it , leads
the home currency depreciation. So the gross
domestic product is influencing the exchange rate
When the inflation rate of a country increases the
currency Depreciate because inflation is inversely
related to the value of currency.
1 Forces That Causes Changes In The Exchange Rate Also Causes
Changes In The
Term Of Trade
2 Real Supply And Demand Shocks Affects Both Relative Prices As
Well As Derived
Demand For Foreign Exchange
3 If The Relation Ship Between Exchange Rate And Term Of Trade Is
Due To Shifts In Real Supply And Demand For Foreign Good And
Domestic Good Than Government Intervention In Foreign Exchange
Market Could Not Effects The Exchange Rate